Mixing Oranges and Onions

Among the more difficult types of contract damages is a claim for lost profits. In instances where the contract is wrongfully terminated, you will need to prove that the affected project would have been profitable and that you were unable to make up the loss through other jobs. This difficulty of proof is amplified where the claim is for lost bonding capacity.

Stated simply, there are situations where bonding companies will suspend the issuance of bonds to a defaulted contractor. If the contractor is primarily involved in bonded work (government contracts), lost bonding capacity can have devastating effects. The loss of profitability is a real damage, but how do you prove it?

Foreseeability and thin skulls

There is a gruesome but appropriately named concept in tort law called the “Thin Skull Doctrine.” If you conk someone on the head, you are liable for the damage even if your victim’s head was surprisingly tender. It does not matter whether you could have foreseen his pre-existing weakened condition. Contract damages are approached differently.

In contracts, damages must be foreseeable to be recoverable. If an owner delays payment without excuse, some contractors may just be annoyed while others may suffer greatly. Given their financial position, they may miss rent payments, and their businesses may be shut down by their unforgiving landlords. An owner may or may not be liable for all consequential damages.

The bedrock case defining foreseeability is Hadley v. Baxendale. In that case, a mill owner sued the railroad for losing a gear, which was shipped for repairs. Without the gear, the mill closed. The mill’s lost profits, according to the court, were not the type of damages the railroad should be liable for unless the railroad knew when it accepted the shipment that it had this kind of exposure.

Courts have been struggling with this foreseeability question ever since Hadley and, often and mistakenly, confuse the question with thin skulls. Here enters the claim for lost bonding capacity.

Predictability of profitability

For an established business in a stable economic climate, say a hotel, future profits may be somewhat predictable. For a contractor, future profits will turn on availability of work to bid on, the likelihood of being low bidder, and the ability to maintain a profitable operation. Some courts have looked at these factors and determined that lost profits, or lost business opportunities, are speculative. In other words, you cannot “foresee” what may never arise. Many courts ruled that these speculative losses were not within the “contemplation of the parties” at the time of contracting.

However, this legal determination is wrong. It presupposes that a contractor could not prove, with reasonable certainty, that it would have earned profits but for the owner’s breach of contract. But would an owner have reasonably expected that a default termination would necessarily lead to a contractor’s loss of bonding?

A recent case

In Denny Constr. Inc. v. City & County of Denver, Colo., 2009, the Colorado Supreme Court established that lost profits resulting from lost bonding capacity were recoverable.

The ruling itself is not unique, as there are other cases that have reached the same result. For example, in Laas v. Montana State Highway Comm’n, 1971, a road contractor recovered losses caused by reduced bonding capacity because a project was delayed by the owner’s breach of contract (failure to obtain a right of way).

Denny, however, mixed tort standards with contract law. Instead of focusing on whether lost profits were foreseeable, the court held that the owner would only be liable if it “should have known” that such losses would occur. According to the Restatement (Second) of Torts, §12, “should have known” is a negligence (tort) concept, which “indicates that the [other party] is under a duty ... to use reasonable diligence” to inquire. In other words, the city and county of Denver had to have a “duty” to know the effects of lost bonding on a contractor. This holding does not make sense.

It is just this kind of confusion that induced the American Institute of Architects to insert a “no consequential damages” clause in all AIA contracts. Courts have often clouded the law on this category of damages.

The proof in Denny

The contractor’s attorneys did a thorough job, and the case is a blueprint for how to present a lost profits claim.

1 A bonding agent testified that the default and the resultant claim against the bond influenced it not to issue additional bonding to Denny.

2 Denny testified about available jobs that could not be bid without a bond.

3 An expert testified about the profitability of Denny’s past work, and the projected profits on unbid jobs.

4 A representative of the Denver government testified that, in its pre-qualification procedures, Denny’s past profitability and its bonding capacity were investigated.

This last element of proof, that Denver had actual knowledge of bonding and profitability, seems to have tipped the balance in Denny’s favor. When the court said that, based on this knowledge, Denver “should have known” the effects of lost bonding capacity, it was not saying that Denver had a “duty” to investigate. Instead, it was saying that the prequalification investigation gave Denver special knowledge, which made lost profits foreseeable. Very confusing.

The indications are, however, that the more the contractor divulges to the owner about its financial position, the more “foreseeable” its potential consequential damages become.